3 Reasons Why Robo-Advisors May Not Be for You

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While robo-advisors may be a fit for certain investors, they’re not for everyone.

Technology has disrupted many industries – newspapers, online travel, movie rentals, taxis and more. Now it is aiming to dramatically change the financial services industry through the emerging use of robo-advisors.

Instead of paying a full-service financial advisor an annual fee that averages around 1 percent, these software programs use automation to select low-cost, passive investments based upon an individual’s risk tolerance and financial goals for a much smaller fee. They’re simple, easy and less time-consuming – all the key attributes of a potentially disruptive new technology. In fact, more than 200 companies have jumped into the robo-advisor space, including large financial giants Blackrock, Fidelity and Vanguard.

This has traditional full-service advisors concerned, and rightly so. Many are unable to differentiate themselves and demonstrate the value that they provide their clients. While robo-advisors may be a fit for certain investors, they’re not for everyone. Here are three reasons why robo-advisors may not be for you.

Unlike robots, investors are emotional. The primary argument against robo-advisors is that clients will not be able to talk to a human being, which is especially important during times of financial panic or euphoria. Retail investors have a painful history of buying high and selling low, and often need the consultation of a professional financial advisor to keep them from making a reactionary decision at the worst possible time.

Just think of the market’s recent volatility when the Standard & Poor’s 500 index dropped more than 9 percent in three days. Would you be comfortable with just a “stay the course” tweet from your robo-advisor? This may work for a young investor with many years ahead of them, but it could be a nightmare for a retiree that is depending on their nest egg for living expenses.

There are many studies that show the negative impact that emotions have on investment returns. In 2014, the average equity mutual fund investor underperformed the S&P 500 by 8.19 percent. The broader market return was more than double the average equity mutual fund investor’s return (13.69 percent versus 5.5 percent). A study by Boston financial analysis firm Dalbar examines real investor returns from equity, fixed income and money market mutual funds from January 1984 through December 2014. The study was originally conducted in 1994 and was the first to investigate how mutual fund investors’ behavior affects the returns they actually earn. ( Past performance is no guarantee of future results. Indexes cannot be invested into directly.) Consider that statistic the next time you’re comparing the price of a full-service advisor versus a robo-solution.

Robo-advisors may use flawed financial theories. Many robo-advisors use modern portfolio theory, which is a financial hypothesis that attempts to maximize a portfolio’s expected return for a given amount of risk. However, it has a number of flaws.

The first is its definition of risk, which is volatility, or the day-to-day fluctuations of a stock’s price. While volatility is one component of risk and can be a significant one for an investor with a short time horizon, it’s an oversimplified definition. Think about private equity versus public equity. Many investors are attracted to private equity because it’s “not correlated” to the stock market. Not true. Rather, private equity is only priced periodically because it’s an illiquid investment. It could be a company in a dying industry with loads of debt on its balance sheet, and according to the modern portfolio theory definition, it would be lower risk than a high-quality, cash-rich, publicly-traded stock that has a beta of 1.5. Being liquid should reduce an investment’s risk – not increase it. Beta measures a portfolio’s volatility relative to its benchmark. A beta greater than 1 suggests the portfolio has historically been more volatile than its benchmark. A beta less than 1 suggest the portfolio has historically been less volatile than its benchmark.

Another major flaw is that modern portfolio theory relies upon historical returns and volatility(apparently the disclaimer “past performance is not necessarily indicative of future results” doesn’t hold water in financial academia). It doesn’t take into account current market conditions, whether it’s technology stocks trading at nosebleed valuations or bond yields at multi-decade lows right as the Federal Reserve is getting ready to raise interest rates. While modern portfolio theory is supposed to lead us to the nirvana otherwise known as “the efficient frontier,” it only looks in the rear-view mirror, which can expose investors to overvalued sectors of the market.

They don’t know you. Robo-advisors are machines that only understand 1s and 0s. Some ask only four questions to determine your risk tolerance and financial goals. They don’t know if you’re looking to buy a house, need insurance, getting divorced, or just had a baby and need to start thinking about saving for college. Our lives are dynamic, and needs and goals can change quickly. Your financial planning needs to adapt also.

Technology innovation over the past few decades has given rise to incredible progress, productivity and efficiency. This has also led to very bold predictions, such as how the internet was going to eliminate the need for brick-and-mortar stores, printing paper, television advertising, etc. Rather than wipe out these industries, technology instead forced change and efficiencies. I believe the same will hold true with robo-advisors. It will force full-service advisors to justify their fees to clients or risk losing business to these automated solutions. However, clients should understand that shopping for discounts can be very costly when it comes to their financial planning.

As the saying goes; price is what you pay, value is what you receive.

US News & World Report